Posted by Dan Karney on Jan 7, 2011

Shortly after Glenn Beck featured Friedrich Hayek’s 1944 book titled “The Road to Serfdom” on his TV program it went to #1 among all books sold on Amazon.com (link), quite an impressive feat for a work published over a half-century ago. Modern scholars of “The Road to Serfdom” hail it as a “war cry against central planning.”

(For those readers unfamiliar with Hayek, he won the 1974 Nobel Prize in Economics for his technical work on the Austrian theory of the business cycle and his social commentaries are often associated with libertarianism.)

“Nor can certain harmful effects of deforestation, or of some methods of farming, or of the smoke and noise of factories, be confined to the owner of the property in question or to those who are willing to submit to the damage for an agreed compensation. In such instances we must find some substitute for the regulation by the price mechanism. But the fact that we have to resort to the substitution of direct regulation by authority where the conditions for the proper working of competition cannot be created, does not prove that we should suppress competition where it can be made to function.” (Hayek, 1944)

While I am not the first to discuss this passage (link), I do find it quite remarkable and thus will comment on each of its sentences in turn.

1) “Nor can certain harmful effects of deforestation… be confined to the owner of the property in question or to those who are willing to submit to the damage for an agreed compensation.” Hayek clear identifies pollution to be a negative externality; that is, pollution harms those not directly involved the economic transaction that creates pollution and thus is “external” to the market. [Interestingly, the final phrase about “agreed compensation” has the flavor of the Coase Theorem even though “The Road to Serfdom” significantly predates Coase’s “The Problem of Social Cost” (1960).]

2) “In such instances we must find some substitute for the regulation by the price mechanism.” Hayek clearly states that negative externalities are market failures and thus cannot be handled by the market alone.

3) “But the fact that we have to resort to the substitution of direct regulation by authority…[emphasis added]” Even the great warrior against social planning says that the government should have a regulatory role when it comes to environmental policy. Given Hayek’s free market inclinations, it seems plausible that he would advocate for Pigouvian-style environmental taxes and tradable permit systems over pure command-and-control regulation, but either way that statement is profound.

Addendum: The American Economic Association (AEA) is currently holding its annual meeting in Denver, CO where thousands of economists gather to exchange research ideas and give paper presentations. At last year’s AEA meeting in Atlanta, GA some economists decided to have a little fun with economic theory and created a rap video about the intellectual differences between Keynes and Hayek. That’s right, a rap video (see here).